Tuesday, April 29, 2008

The Root Of All Evil Necessity

The best financial analysts known to man*

Bank of England Governor Mervyn King has been laying into the City "bonus culture". He's told the Treasury Select Committee that huge performance bonuses may act against the long-term interests of banks and their shareholders, because they give bank employees an overwhelming incentive to take heads-I-win-tails-you-lose risks.

He also said it is primarily the banks who are to blame for the credit meltdown: it is they who built the bonus culture, and it is they who designed the dodgy financing structures that have now incinerated.

And nobody can seriously disagree. As we've consistently argued on BOM, the banks and their shareholders have had the upside, so they must take the downside. And they must learn the lessons in terms of future risk control, part of which may well involve restructuring staff performance incentives.

Fine.

But to say the banks are ultimately to blame for this crisis is not the same as saying risk-taking banks are A Bad Thing. A modern economy needs innovative risk-taking financial institutions. Growth depends on capital being channeled into areas of greatest return, and Britain has also benefited massively from providing such financial services to the rest of the world.

Unfortunately, finance has never been an exact science: it is messy and wasteful. And sadly, there is no alternative. If you want the innovation and growth, you have to accept the mess that goes with it.

Of course, over the years sensible mature economies have learned from their disasters, and developed techniques to manage and control the worst of the risks, largely in the shape of regulation. So although the banks must shoulder the bulk of the "blame" for what's happened this time, the regulators are also centrally in the frame.

Which brings us back to the FSA, and the publication of the full - though still heavily expurgated - audit report on its handling of the Crock fiasco (see this blog for earlier summary release).

There are some horribly familiar findings:

Danger signals ignored - the FSA ignored a slew of danger signals from the Crock over many months before it hit the wall; these included dropping below its permitted minimum capital requirements ratio - which is supposedly a red card event - yet virtually simultaneously announcing it was planned to pay higher dividends to shareholders.; there were seven other critical danger signals ignored;

Silo mentality - not only did FSA officials ignore an October 2006 Bank of England paper sent to them outlining the risks facing the Crock, they also seem to have ignored each other: "FSA officials were described as “defensive” and “territorial” in the face of problems".

Regulatory capture - FSA officials were cowed by “strong and aggressive characters within Rock’s management team” (actually, that's less capture and more capitulation).

It's the same old story: never ever give an important task to a quango or a government department, because they will screw it up. So WTF would anyone give the tricky job of regulating banks and other financial companies to a brand new quango?

Ever since it was set up by Brown in 1997, the FSA has been a bad joke among City professionals. Talk to any of them over a couple of unattributable beers, and they'll tell you the same thing: the FSA is simply not capable of regulating the financial system.

For one thing, those hungry financiers are always finding new and unexpected ways of making money. It's a tough job for anyone to keep up.

And for another, the people who end up working for the FSA are a lethal combination of the inexperienced and the second-rate.

Partly, that's down to pay and rations: although FSA employees may get paid a fortune compared to DWP staff in the North East, it's nothing against what the best people can earn in the City itself.

But it's also down to the job itself: who in their right mind would want to work for a quango dancing to the tune of people like Brown and Darling? Especially knowing that at the first sign of trouble, they will throw you to the crocs.

As we've said before, Brown still crows about how his decision to make the Bank independent laid the foundations of a 1000 year economic paradise. But the truth is that his accompanying reorganisation of financial regulation was as half-baked as everything he's touched since.

Bank regulation should be returned to Threadneedle Street soonest.

*Footnote - the indecipherable chart is taken from the FSA's monitoring analysis of the Crock. As the excellent FT Alphaville said, it looks like it was run off on a 20 year old Amstrad (HTP Joan W).

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